Wednesday, 15 October 2008

BrainBoxx : Why are we all going bust?

We all know the world is in financial turmoil right now, and some people are even calling this the start of a recession. But what does that mean?

To try and make things clearer today I am going to be focusing on why this happened, what we are trying to do to fix it and how this is going to affect us in the future.

No 1: Why?

A loan is when a bank gives you a sum of money that you have to pay back over a period of time with interest. It used to be that banks were very strict as to whom they gave out loans. They had to make sure you were definitely capable of paying it back by looking at things like how much you earned and your reliability of paying back loans in the past.

This changed about a decade or so ago when banks in America started encouraging people with low income, who weren’t really capable of paying back large amounts of money, to take out massive loans to buy property. This trend eventually spread worldwide.

Now, a large amount of these loans started to default, which means people simply couldn’t pay the money back.This was ok for the banks because they would simply reclaim the property and, seeing as this was a time when house prices were on the rise, they could sell on this property for more than the loan they had given to the previous owner, therefore making a profit.

This is when the problems began.

House prices work on a cycle of supply and demand. When more people want to buy houses, this creates demand, therefore they are more willing to pay higher amounts of money, so prices go up.However they then reach a point when prices get too high for most people to be able to afford to buy, therefore less people buy houses, the price drops and then the cycle continues.

So when prices started to go down a year or so ago this was bad news for the banks.They started to have to sell the houses for less than the loans they had given their clients. Making a loss.Fast forward to the present day and the banks are losing so much money they are going bust.

This has also lead to a freeze up of the markets caused by the fact that the banks are no longer lending money to each other purely because they are scared of the possibility that whomever they lend to could go bust tomorrow.

Now. No 2: What are we doing to get us out of this mess?

Here is what would happen if we didn’t intervene. The big banks that made huge profits from these loans that are now going bust would simply collapse.This would mean short term chaos, not just for the business and financial world, but also for normal people who rely on these banks to look after their savings and provide them with things like overdrafts.This would leave us with the smaller banks who couldn’t afford to take these high risk loans. They would eventually grow and take the place of the big banks, after which financial normality would be restored.

Governments around the world don’t seem to be willing to let this happen because of the initial turmoil that would ensue. What they intend to do will depend on where you are in the world.In the UK Gordon Brown has instigated a nationalisation plan, in which the government has bought up the banks, basically meaning that the majority are now state owned. This means that the government should be able to have some control of the bank’s behaviour in the future, potentially having the ability to prevent another crisis like this.Government in main land Europe are also in talks about putting into practice a similar plan.

In the USA the Bush administration has decided to take a different approach. Instead of taking control of the banks they has proposed to give US banks $700 billion which will be used to pay for the ‘toxic loans’ that the public can’t pay back.There is however a call for a similar plan to Britain and the rest of Europe.Regardless both tactics have been very controversial and has seen an outcry from taxpayers who don’t see why they have to pay for the bank’s mistake.Whether this is fair or not is up to you.

In terms of how this will affect us in the future (No 3) there are conflicting opinions.

On the one hand there are those who say this is simply a blip on the radar, others say this is the beginning of a great recession.In the UK and Europe, seeing as we assume governments will have a say in future proceedings of their banks we can hope money lending could become more responsible.However in the US there is a danger that those who are being bailed out are still in charge without a scratch on them, and there is a danger they will continue to act irresponsibly.

Regardless in the future we are going to have to wade through a whole lot of crap. We will have to deal with rising unemployment, fuel poverty and less spare money to spend on our high streets. It is up to those that we have put in charge to make sure we survive, whether it is just a blip, or something bigger.